Feb. 21, 2013
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M&A activity has jumped more than 45% in the fourth quarter. / Thinkstock

by John Waggoner, USA TODAY

by John Waggoner, USA TODAY

When two companies love each other very much, they get together, and sometimes that's where brand-new bouncing baby businesses come from. Other times, one company loves another company so much that it just gobbles it right up. And sometimes, just sometimes, investors can profit from all that love - but it's not easy.

Just as spring approaches, Corporate America has been struck by the urge to merge. U.S. M&A activity soared to $306.2 billion in the fourth quarter of 2012 from $210.2 billion in the third quarter, according to The Mergermarket Group. Corporate hookups have made big headlines this year: American Airlines and U.S. Airways agreed to merge in an $11 billion deal, Berkshire Hathaway bought Heinz in a $23 billion agreement, and Office Depot agreed to buy Office Max in a $1.2 billion deal.

One reason for the uptick in M&A is the soaring stock market itself. A company that wants to buy another with stock, for example, has greater buying power when the stock is at $40 than when it's at $20.

But the prime mover behind the fecund M&A market is huge cash hoards, thanks to years of record or near-record profits. Excluding financial companies, which must keep lots of cash at all times, 205 companies in the Standard & Poor's 500-stock index have $1 billion or more in cash on their books.

Shareholders get restless when a company has too much cash on its books. After all, shareholders are owners, and they want to share in the love, too. Recently, for example, hedge-fund manager David Einhorn has been pushing Apple to return some of its $40 billion in cash to investors in the form of a special dividend.

Special dividends are, well, special, but many times, companies prefer to put their profits to work, typically by expanding the business. One way, of course, is to open new branches, hire more employees, and roll out new products.

Another way is to buy another company whose line of business is complementary to yours. The merger between American and U.S. Airlines, for example, got good marks because the two companies had relatively little overlap in their routes.

But there are plenty of dangers in M&A, the first being the temptation to do something stupid. Companies that wed in haste often repent at leisure - as Time Warner did when it bought America Online. And sometimes companies that seem well-suited to each other just aren't.

What does this mean for you as an investor? One frequent observation about M&A is that the stock of the acquiring company typically falls, while the price of the target often rises. The reason for this is relatively simple: The purchaser usually overpays.

The phenomenon is so well-established that a few funds have made decent money by waiting for a takeover announcement, buying the target, and shorting the stock of the acquiring company. ("Shorting," on Wall Street, means making a bet on a falling stock price.)

The strategy is actually fairly conservative. The Arbitrage fund (ARBFX) one of the oldest funds that follows the strategy, has an average return of 4.3% a year the past decade, vs. 7.9% for the S&P 500 with dividends reinvested, according to Morningstar. But it's far less volatile than the S&P 500: The fund's worst 12-month loss has been -12.5%, vs. -43.3% for the index. Another, similar fund is the Gabelli ABC fund (GABCX).

Investors looking for a big pop from M&A activity should realize just how difficult it is to find a merger target before the merger is actually announced. Generally speaking, though, targets tend to be in the small- and midcap range, says Todd Rosenbluth, director of mutual fund and ETF research at Standard & Poor's. "It's easier to buy a $1 billion company than a $50 billion one," he says.

Targets typically fall into two categories:

â?¢ Unloved, overlooked companies that could be turned around by a purchaser. Heinz could fall into that category, although the ketchup king was always solidly profitable. It took Warren Buffett's Berkshire Hathaway to make the company sexy.

â?¢ Red-hot companies that larger companies figure are worth buying. Oracle, for example, recently bought a small company called Acme Packet, a networking firm, for $2.1 billion.

Although many on Wall Street try to figure out merger targets before they're announced, few are successful. (And some that are successful are hauled before the Securities and Exchange Commission, because using insider knowledge of M&A information before it's public is a very bad thing.)

Generally speaking, then, you should probably be looking at a midcap fund if you're hoping for a prolonged boom in takeover mania. A midcap growth fund will be more likely to own stocks like Acme Packet; a midcap value fund could have the next Heinz in its portfolio.

If you've lived through the past decade, midcap growth funds may well give you the willies, so the chart has the best midcap value funds for the past five years. If you're in a growth mode, however, consider Primecap Odyssey Aggressive Growth (POAGX), which has gained an average 11.3% annually the past five years.

Not all corporate marriages have happy outcomes, and profiting from them isn't easy. For most investors, the best takeaway from the boom in mergers is that companies now feel confident enough in their profitability and in the economy to spend some of their cash. It's not the sort of thing that will make you swoon, but it should bring at least a smile to your lips.